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After VWO's Index Switch, Will South Korea Fade?

Arguably the biggest news to hit the exchange-traded products industry this year arrived earlier this week when Vanguad, the third-largest U.S. ETF issuer, announced it would part ways with MSCI (NYSE: MSCI) indexes used on 22 Vanguard funds.

The most marquee of the marquee Vanguard ETFs dropping MSCI indexes is the Vanguard Emerging Markets ETF (NYSE: VWO), the largest emerging markets ETF. VWO will drop the MSCI Emerging Markets Index in favor of the FTSE Emerging Markets Index.

U.K.-based FTSE Group said the index change is the EEM). That difference being the fact that South Korea is not part of the FTSE Emerging Markets Index because FTSE Group, along with several other noteworthy organizations does not view South Korea as a developing nation.

MSCI does consider South Korea emerging and to that end, the Asian economic power represents 15.4 percent of EEM's weight, making it the ETF's second-largest country weight after China.

To the naked eye, news of Vanguard's new index choice might seem like bad news for South Korean equities and the iShares MSCI South Korea Index Fund (NYSE: EWY). EWY, which has almost $3 billion in assets under management, is not only the largest South Korea, it is one of the largest country-specific emerging markets funds of any stripe.

The fund fell by just under one percent on Tuesday when Vanguard announced its index switch and even that may have been an overreaction, according to Morningstar Research Director Paul Justice.

"There was no market dislocation for EWY on this news," Justice said in an interview with Benzinga from the Mornginstar ETF Conference in Chicago.

Regarding any potential downside for South Korean equities, and by virtue EWY, as VWO moves to an index that excludes the country, Justice does not expect massive selling pressure that could lead to a buying opportunity.

"The care and caution taken by Vanguard will be the determinant of how well the process goes," said Justice.

For its part, Vanguard, the third-largest U.S. ETF sponsor, has already assured investors that its sale of South Korean equities will be gradual and orderly. Assuming that proves to be the case, it appears EWY will not endure any undue punishment. On Wednesday and through the early part of Thursday's trading session, the ETF has taken back essentially all of its Tuesday loss.

"New of the Vanguard index switch is not going to impact the underlying value of South Korea," Justice noted.